Ruminations of an Israeli-American Venture Capitalist Looking for the Best and Brightest Entrepreneurs

Wednesday, September 22, 2010

Soap and Oil in Paid Acquisition Strategies

When your business depends on driving quality traffic to your website, embracing a paid acquisition strategy using SEM or display advertising can be both a luxury and a nuisance. It’s a luxury, because you can effectively manage your rate of growth via variable marketing dollars. With great precision, successful Internet companies know what kind of return to expect on every dollar spent and can comfortably raise their spending level month over month.

But as anyone familiar with Internet marketing will tell you, scaling a paid acquisition model is rarely as simple as doubling down on AdWords or opening up to affiliates. This is simply because your ability to effectively scale ad spending depends on maintaining an acceptable customer acquisition cost ratio (CAC ratio) relative to your best estimate of your customer lifetime value (CLTV). You may run a fantastic campaign on a certain combination of key words, or on a certain publisher’s website, only to find that you have quickly exhausted the cheap inventory or that you wound up acquiring customers at a prohibitive marginal cost. And if the economics aren’t consistently attractive, affiliates will never work with you in the first place.

It is often said that successful Internet models are about “lather, rinse and repeat,”and while there is a lot of truth in this most companies have to try and use a variety of soaps, before they can really follow these instructions. Such experimentation means that successful paid acquisition strategies will often be an expensive nuisance to the company before it can truly be a luxury. Not surprisingly, many companies find that mastering the science behind customer acquisition will be more challenging than the science behind the product they are trying to sell. However, when executed properly, the company will have created a well oiled marketing machine that will become a core competitive advantage.

The uninterrupted search and discovery for new sources of cost effective traffic most resemble the search and discovery efforts in oil and gas. It requires lots of drilling and patience, and there is a time lag between an initial investment and assessing your ROI. When a company does finally strike oil, not only is it unclear how much oil is available, buts it’s also unclear how much it will cost to extract each barrel of oil (marginal acquisition cost). And even then, the company’s economic interest in extracting the oil at a given cost depends largely on the prevailing price of oil (similar to your CLTV which can also rise and fall). Luckily, web companies don’t need to spend as much up front or to wait as long for a return, but I think the analogy is apt.

With many Israeli start-ups adopting paid acquisition growth strategies in recent years, I want to draw attention to several types of early stage companies I have encountered. The first type are companies which have demonstrated positive unit economics on very limited ad spending (<$10K/month), and which have concluded that they can easily double their revenues several times over by simply raising their marketing spend (which I am asked to fund). The second type of early stage company has already decided to halt their limited paid acquisition experiment after experiencing unattractive unit economics on limited ad spending over a short period of time.

The reality is that both types of companies would be mistaken to draw too many conclusions on such limited spending. The first type of company should keep testing the limits of their marginal CAC to discover how far they can really go until a ceiling is hit. And the second type of company should exercise more creativity and patience in running campaigns, not completely forgoing a paid acquisition strategy until more advanced revenues set in with a better sales strategy.

There is also third type of early stage company that I encounter which successfully generates traffic and customers using a variety of “free” methods, including SEO, PR, viral and social media. This type of company grows nicely month over month, and therefore can’t fathom the idea of paying for the traffic directly. They even look down on those who spend to buy each of their customers. While some companies' growth rates completely support a strong stance against paid acquisition, I strongly believe that companies should continually experiment with their traffic acquisition methods as the growth potential from paid acquisition may positively surprise even if it is a lot more expensive than “free.” Moreover, the competition may discover and then master this paid acquisition strategy putting the company at a real disadvantage when their free methods start running out of steam. I recently came across this quote from the founder of Wesabe, which was steamrolled by Mint: "Mint aggressively acquired users by paying for search engine marketing (reportedly spending over $1 for each user), while Wesabe spent almost nothing on marketing; yet in the end we grew at about 1/5th the rate they did."

These days, there are several promising Israeli start-ups hitting their groove with scalable paid acquisition models, including my own portfolio company Wix. Surprisingly, there have also been several Israeli exploration companies striking it rich with natural gas discoveries, but we won’t touch those! I don’t think oil companies and Internet start-ups have too much in common, except persistence, patience and rigorous economic analysis day after day. And just remember that companies must dirty their hands as if searching for oil, before they can enjoy the simplicity of lather, rinse and repeat.

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The thoughts and opinions expressed herein belong to the author and do not necessarily reflect those of Bessemer Venture Partners or any of its affiliates (“Bessemer”). The material here is written on the author’s own time for [his/her] own reasons and Bessemer has not reviewed or approved the information herein. Any discussion of topics related to Bessemer or its investment activities should not be construed as an official comment of Bessemer.